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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   April 2017

Financing Sustainability

PACE loans provide alternative funding for energy-efficiency improvements

Financing Sustainability

Over the past several years, Property Assessed Clean Energy (PACE) loans have increasingly become part of commercial mortgage originators’ ongoing conversations with property owners. For originators, PACE loans provide a growing opportunity to engage property owners in discussions about their larger capital investment needs — energy or otherwise — and the innovative financial tools available to them. It also is an opportunity to open a conversation with contractors and builders who make major capital upgrades on commercial properties, creating potential new touch points in their networks.

Commercial mortgage brokers adept at business development — especially those with considerable volume in small-balance commercial loans — proactively keep customers and prospects on the forefront of the financial solutions available to them. They reach out between financings, bring changes in the industry to their attention, and present themselves as available to field questions and sort through priorities. They become partners invested in the borrower’s business.

With new technologies becoming available, green energy is increasingly a part of the dialogue between brokers and owners. These discussions can be part of social-responsibility programs or for more pragmatic reasons, such as reducing operating costs on properties or businesses.

Until now, however, the focus for clean energy programs has been mainly on large Class A commercial properties, especially marquee buildings with symbolic values like corporate headquarters, for instance. Although these large investment-grade office and retail buildings are big energy consumers, have abundant access to capital and plenty of financing options for capital and equipment improvements, they represent less than 1 percent of the commercial building stock.

The other 99 percent of commercial buildings have few capital sources for funding building improvements ahead of core business priorities. Instead, they are typically limited to using scarce operating dollars to patch up old equipment. Some owners must replace equipment piecemeal as it breaks, even if that tactic may prove more expensive over the long run. Despite the availability of Small Business Administration 504 financing providing an attractive option, many small and midsized commercial property owners have not been able to upgrade their energy systems to their satisfaction.

Growth of PACE

It is exciting, then, to see that small-business properties are now driving growth in the newest and, perhaps most promising, financial solution for green energy: commercial PACE loans. Many commercial property owners see building upgrades as a pain point, so a broker who brings ideas to ease that pain will be the broker who gets a call when heating, ventilation and air conditioning, or HVAC, systems break down, or when energy bills are higher than the owner budgeted or other capital-improvement priorities come forward.

With 100 percent upfront financing that gets repaid out of energy- and water-bill savings over the full lifetime of upgrades, PACE loans allow these commercial properties to pursue the scale of upgrades they need. Small and midsize properties are at the center of this growth.

The first commercial PACE project funded in Connecticut was a family-owned retail center that borrowed $170,000 in PACE financing to install high-efficiency lighting in the property’s parking lot as well as a small solar system. Since then, Connecticut and other markets have grown considerably, mainly around properties and projects of the same size.

Other states are advancing along similar lines. The first Maryland commercial PACE financing involved retrofitting a hotel and professional building near Gaithersburg in Montgomery County. Upgrades to the HVAC systems and lighting, plus some other improvements, are expected to reduce the buildings’ operating costs by about $140,000 per year.

The Texas commercial PACE program is getting underway this year. One family-owned small retail property in Bryan, Texas, is financing installation of a 20.8-kilowatt solar system and upgraded high-efficient LED lighting as well as the replacement of broken HVAC units and a failing roof. These combined improvements will allow the property owners to capture more than $200,000 in savings over the life of the equipment. The total project amount of $130,000 was completely financed through a commercial PACE loan.

The assessment for commercial PACE financing on these projects will show up as a line item on the borrowers’ property tax bills. Like a tax, this financing will automatically be transferred along with the improved building to a new owner. PACE financing typically features fixed interest rates and terms of up to 20 years. PACE financing for commercial projects complements conventional debt and can be a less expensive approach to mezzanine financing.

Future of PACE

Navigant Research reports that by 2025 the potential market for small and midsize commercial energy retrofits is expected to reach $37 billion. PACE is one of the fastest-growing financing options for clean or efficient energy. To date, more than 30 states have passed PACE legislation, and 19 states plus the District of Columbia have active PACE programs, and new programs are being added regularly. Aiding this acceleration among local governments, PACE Financial Servicing (PFS) offers outsourced PACE administration at no cost to local governments.

PACE financing can range from thousands to millions of dollars. Tenants benefit on the expense side through lower energy costs, helping offset any increases in property taxes passed through to tenants. PACE funding is nonrecourse, has no covenants and is transferable. The obligation is linked to the property, allowing for low long-term interest rates.

Where an existing mortgage is in place on the property, most states require consent from any underlying lender with a current lien on the property before approving PACE financing. PACE assessments, like property taxes, do not accelerate during a foreclosure, tax sale or bankruptcy. Lenders agree to be subordinate in terms of the lien position to what is essentially considered to be late property taxes. More than 200 lenders have consented at the time of writing, and this number is growing.

Lenders that consent see the advantage in the ability of PACE projects to add to the value of their collateral. In addition, the long payback periods of PACE loans allow most projects to be cash-flow positive from day one. Payments can be amortized through the cumulative useful life of a project.

In most cases, annual energy savings exceed PACE payments, increasing cash flow to the property owner and raising net operating income year over year. That cash flow increases the ability of property owners to pay existing mortgages and other expenses. Plus, decreasing the property’s operating costs increases the debt-service-coverage ratio.

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Because of all of the benefits discussed here, building owners are increasingly demanding the ability to fund capital improvements using PACE loans. A broker well versed in the PACE process can be an important partner, expert and guide for their clients when navigating and evaluating new or existing mortgages.


 


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